Alexandria, VA (February 18, 1999) -- Is the Dow out of date? That's what we began discussing last week, when we looked at the recent divergence between the Standard & Poor's 500 Index and the Dow Jones Industrial Average (DJIA). Historically, the two indices have returned similar amounts, but in each of the last two years the Dow has lagged the S&P by more than ten points. This is possibly part of the reason for the Foolish Four's recent losses to the S&P, and it has led some people, as described in a recent issue of Fortune, to question the relevance of the Dow.

The most common response is to assume that the Dow is overweighted in industrial stocks and underweighted in technology stocks. That may be a little simplistic, but I think there are signs that the Dow does need to be updated.

First, let's define what the Dow is. According to the Dow Jones website, "The DJIA is an index of 30 'blue-chip' US stocks" -- not including transportation and utility stocks, which have their own indices. The stocks are selected by the editors of The Wall Street Journal, and "the components of the DJIA are not changed often. It isn't a 'hot stock' index, after all," the editors sniff. Yet they do consider the DJIA a "market indicator" that "reliably indicates the market's basic trend."

This raises a couple of questions. First, there's the whole question of the DJIA's size, which has been fixed at thirty stocks since 1928. Is that really enough to track the 10,000 or so public companies out there? I don't have enough space to address that question fully, but it's certainly something for the Journal editors to consider.

Secondly, if the Dow is a market indicator, it does need to change with the times, even if it isn't going to be a "hot stock index." The Dow last changed in 1997, when it replaced Woolworth Co. [now Venator (NYSE: Z)], Westinghouse [now CBS(NYSE: CBS)], Bethlehem Steel(NYSE: BS), and Texaco (NYSE: TX) with Hewlett-Packard (NYSE: HWP), Wal-Mart(NYSE: WMT), Traveler's Group [now Citigroup (NYSE: C)], and Johnson & Johnson (NYSE: JNJ). These changes made sense, but as the Fortune article asked, why was Bethlehem Steel still in the index as late as 1997?

To further look at this question, consider this informal grouping of Dow companies:

Of course, there are many ways to do this classification. As many Fools pointed out in e-mail to me, there are plenty of companies like GE, United Technologies, and even Eastman Kodak and Disney, that are involved in technology to some degree.

Nevertheless, all the companies that I've classified as "industrial" do a lot more manufacturing than a Microsoft or even a Cisco, which outsources a lot of its industrial work. Of course, all the companies that I've classified as industrial are large and employ a lot of people, so most of them should be included in any index purporting to represent the American economy.

For example, seven of the 10 largest and about 15 of the 20 largest U.S. companies, by revenue, are in the Dow (I say "about" because the rankings have changed with the merger of Citicorp and the Travelers Group). These large companies include those that might seem outdated, such as Sears, which in 1997 ranked 14th among U.S. companies in sales with $42.3 billion and 11th in employees with 334,000 people. Clearly, not everyone works for a high-tech company, despite all the attention those companies get.

Nevertheless, there a couple of Dow companies that aren't so large anymore. To my mind, International Paper and Union Carbideare obvious candidates for replacement. International Paper ranks 53rd among U.S. companies in sales, while Union Carbide is 221st behind companies like Apple(Nasdaq: AAPL), Humana(NYSE: HUM), and Kellogg(NYSE: K). Why continue to include these two? Alcoa and AlliedSignal are also potential replacement candidates.

What companies should replace them? This is a much more interesting and difficult question. There aren't any real rules for what companies can be included in the Dow, beyond some basics about price and liquidity. The editors seem to prefer companies on the NYSE that pay dividends, but neither characteristic is actually required. Certainly as Dow dividend investors, we'd prefer for companies in the Dow to pay dividends.

With that in mind, I'd argue that either Intel(Nasdaq: INTC) or Lucent(NYSE: LU) would make an excellent candidate for one of the two slots, and that would probably make the technology sector adequately represented. The retail/service sector should also have greater representation, and one candidate would be Home Depot(NYSE: HD), which ranked 39th in the 1997 list of largest U.S. companies with $24 billion in revenue. Grocery chain Kroger (NYSE: KR) and retailer Kmart(NYSE: KM) have higher revenues, but neither pays dividends.

Another candidate would be a large media conglomerate such as Time Warner(NYSE: TWX). The media sector is currently only represented by Disney, and considering Time Warner's multiple properties, from cable to publishing to movies, its inclusion would make a lot of sense.

So, which should it be? Fools with strong opinions about how (or whether) the Dow should be updated can let me know which companies they would replace, and with what. Next week, I will report on your thoughts.

A couple of final notes on this: if the S&P as an index is doing that much better than the Dow, what about using Dow strategies with the S&P? Good question, and Ann Coleman took a look at it last Friday. And check out today's Breakfast News, which reports that the Dow Jones company has added a couple of Internet indices to its lists, which should be interesting to track. Fool on!